Post-Brexit, while there will be knock-on impacts from any UK downturn in trade with continental Europe, these will be small: UK trading forms only a small part of continental European gross domestic product. Brexit is an asymmetric shock with the UK at the centre.
Continental European businesses may also behave more cautiously in their investment decision making due to higher levels of uncertainty, but we think these will be materially less than any uncertainty issues evident in UK business investment decision making over the next while. There are of course still issues to work through in the continental European economies, such as the state of the Italian banking system, but this does not represent a change per se in what we already knew. Unless something goes dramatically wrong in continental Europe from here, we think this is primarily a UK issue and that has definite implications for how we approach our investments.
The factors that we will have to monitor are: when does the UK activate Article 501 and, indeed who has the power to do it?; how pragmatic will the prime minister be in their negotiating stance?; and what is the reaction of the broad policymaking establishment in the EU-27 and what negotiating stance do they take?
We believe the key long-term trade-off for the UK may come down to single market access versus freedom of movement of people. While we are sympathetic to the idea that UK businesses should seek longer-term opportunities outside of Europe in the faster growing parts of the world (as many of our German, Spanish, French and Swedish holdings have already done), we believe that exiting the single market without a trade agreement in place would be materially negative to the UK’s economic prospects for at least a few years and an act of self-imposed economic harm.
We also do not believe that reducing free movement of people is in the UK’s economic interest and that the government would be better off using the extra taxes that migrants bring to the UK to increase investment in UK public services so as to placate those who do not understand the positive economic implications of migration. How these factors of the Brexit process evolve over the next quarters will influence how we invest and where we position the portfolio with particular implications for any indirect UK exposure. Irrespective, of what happens in the long-term to the UK’s relationship with the EU-27, we believe that our long- standing holdings backed by winning business models such as Inditex, Paddy Power Betfair, Fresenius SE, Schindler, Ryanair, LVMH, Henkel, Pernod Ricard, AB Inbev, Hexagon, Kingspan and SAP will continue to thrive and during a period of uncertainty, we may choose to emphasise them more heavily in the fund. The key to decide is whether the more domestically-exposed, cyclical stocks that we are holding in anticipation of improving fortunes in eurozone economies have a different future in front of them. And of course whether those stocks that have some UK exposure have been oversold.
We are heading into a period of uncertainty that will last at least a few months and, before dipping into the market buying further positions in such stocks, we should wait to see how the economic shock from the Brexit vote ripples out. It is also paramount to make a distinction between stocks; companies such as Kingspan, Ryanair and Paddy Power Betfair have much stronger structural growth drivers and lower levels of operational gearing; we may therefore not add into each stock in relation to its underperformance but instead chose to prioritise certain stocks. Irrespective, we believe the broader point that continental European equities have been oversold and this will be borne out in the medium-term. The medium-term prospects for European equities are good.